WPS3938
Creating a More Efficient Financial System:
Challenges for Bangladesh
Thorsten Beck and Md. Habibur Rahman
Abstract: While Bangladesh has embarked on a path to reform its financial system, most
prominently by privatizing its government-owned banks, the Nationalized Commercial Banks
(NCBs), a sustainable long-term expansion of the financial system requires a more substantial
change in the role of government. Using recent research and international comparisons, this
paper argues that the government should move from its role as an operator and arbiter in the
financial system to a facilitator role. This implies not only divestment from government-owned
banks, but also de-politicization of the licensing process and a market-based bank failure
resolution framework that focuses on intermediation and not on the rescue of individual
institutions. Most importantly, the government should move away from the implicit guarantee for
depositors and owners to applying the existing limited explicit deposit insurance for depositors,
while simultaneously relying more on market participants to monitor and discipline banks instead
of micro-managing financial institutions. This redefinition of government's role should not be
limited to the banking system, but applies to other segments of the financial system, such as
capital markets and the micro-finance sector, and should be seen as an essential element in the
governance reform agenda and in the movement from a relationship-based economy to a market
and arms-length economy.
World Bank Policy Research Working Paper 3938, June 2006
The Policy Research Working Paper Series disseminates the findings of work in progress to encourage the
exchange of ideas about development issues. An objective of the series is to get the findings out quickly,
even if the presentations are less than fully polished. The papers carry the names of the authors and should
be cited accordingly. The findings, interpretations, and conclusions expressed in this paper are entirely
those of the authors. They do not necessarily represent the view of the World Bank, its Executive Directors,
or the countries they represent. Policy Research Working Papers are available online at
http://econ.worldbank.org.
* Beck: World Bank, Rahman: Bangladesh Bank. This paper is a background paper for:
"Bangladesh: Strategy for Growth and Employment". Comments and suggestions from
Juan Costain, Aurora Ferrari, Sandeep Mahajan and participants of seminars in the World
Bank in Dhaka and Washington D.C. are gratefully acknowledged. We are grateful to
Edward Al-Hussainy for outstanding research assistance.
1. Finance as key to faster economic development
Bangladesh has experienced fast economic growth over the past years, with an average
real GDP growth rate of 5.3% over 2000-2004. While population growth of 1.7% has resulted in
average annual real GDP per capita growth of only 3.5% over this period, this is still higher than
the 1.8% that the average low-income country enjoyed over the period. At this stage, it is crucial
to design and implement policies that allow Bangladesh not only to sustain the recently achieved
growth rates, but to accelerate economic development and achieve middle-income status within a
generation. Among the policies identified by researchers to be associated with faster economic
growth are policies that foster a sound and effective financial system. However, there is a large
variation across countries in the efficiency with which financial institutions and markets reduce
transaction costs and information asymmetries, with important repercussions for economic
growth and development.
Countries with better developed financial systems, i.e. financial markets and institutions
that more effectively channel society's savings to its most productive use, experience faster
economic growth. 1 Table 1 and Figure 1 summarize a well-established body of empirical
evidence; countries with higher levels of credit to the private sector relative to GDP experienced
higher average annual real GDP per capita growth rates over the period 1980 to 2003. 2 Private
Credit and other factors associated by the literature with economic growth explain 51% of
variation in real GDP per capita growth. 3 The log of initial GDP per capita enters significantly
negative, confirming the conditional convergence of countries' real GDP per capita, while
1To be sure, there is also a feedback of faster economic growth on the development of the financial system.
2Private Credit is a standard measure of financial intermediary development and is the ratio of claims by deposit
money banks and other financial institutions on the private, domestic non-financial sector relative to GDP. Private
Credit was 173% in the U.S. in 2003, but only 2% in Mozambique.
3The set of explanatory variables follows a standard regression set-up from the finance and growth literature, as
used e.g. in Beck, Levine and Loayza, 2000).
1
average years of schooling, an indicator of accumulated human capital, enters positively and
significantly. While population growth enters negatively and significantly, none of the other
variables often associated with economic growth enters significantly.
The relationship between financial intermediary development and economic growth is not
only robust to controlling for other factors that are associated with economic growth, but to
controlling for the reverse causation from faster economic growth to financial development and
to the relationship being driven by a third factor. While Figure 1 shows the relationship between
private sector lending and GDP per capita growth, other measures of financial development, such
as M2 to GDP or the turnover ratio in stock markets, yield similar results (Levine , Loayza and
Beck, 2000; Beck and Levine, 2004). These findings are confirmed by cross-country, panel and
by time-series estimation techniques (see Levine, 2005 for an overview).
The relationship between Private Credit and GDP per capita growth is not only
statistically, but also economically significant. The results in Table 1 suggest that a doubling of
private sector lending to GDP in Bangladesh over the period 1980 to 2003 from 22% to 44%
would have resulted in 0.7 percentage points higher growth, or 2.7% instead of 2%.4
Financial markets and institutions arise to alleviate market frictions that prevent the direct
pooling of society's savings and channeling to investment projects. Well developed financial
systems ease the exchange of goods and services by providing payment services; help mobilize
and pool savings from a large number of investors; acquire and process information about
enterprises and possible investment projects, thus allocating society's savings to its most
productive use; monitor investments and exert corporate governance; and help diversify and
reduce liquidity and intertemporal risk (Levine, 1997 and 2005).
4Such counterfactuals have to be interpreted with caution as the coefficients indicate marginal effects from which
we are extrapolating to discrete changes. Further, this counterexample serves an illustrative purpose; it does not
actually tell us how to achieve higher growth rates.
2
Financial development is not only pro-growth, but also pro-poor. Figure 2 shows the
relationship between Private Credit and the average annual change in Headcount ­ the share of
population living on less than one dollar a day ­ over the period 1980-2000. The graph is based
on a regression of the annual growth rate of the Headcount on Private Credit, GDP per capita
growth and the log of initial Headcount (Beck, Demirguc-Kunt and Levine, 2004). By
controlling for average economic growth we thus control for the positive effect that financial
intermediary development has on poverty reduction through faster economic growth.5 The
negative relationship between Private Credit and changes in Headcount even after controlling for
economic growth thus suggests that financial intermediaries have a positive impact on the poor
beyond its impact on overall economic development. As shown by Beck et al. (2004), this
relationship is robust to controlling for other country characteristics such as government
consumption, inflation, openness and population growth, as well as to controlling for reverse
causation and simultaneity bias. As in the case of the finance and growth relationship, the
importance of finance for poverty reduction is not only statistically significant, but also
economically. Bangladesh would have experienced a greater poverty reduction had it had a
higher level of Private Credit over the past 20 years.
While Table 1 and Figures 1 and 2 show the importance of private sector lending for
economic growth and poverty alleviation, Private Credit is not a policy variable itself. To the
contrary, bigger is not always better. A rapid increase in private sector lending, not supported by
the macroeconomic, contractual and informational framework discussed below, can result in
fragility and banking crises, as experienced by many countries over the past 30 years (Demirguc-
Kunt and Detragiache, 1999; and Caprio and Klingebiel, 1997).
5Changes in poverty can be decomposed into economic growth and changes in income inequality (Bourguignon,
2004). Kraay (2006) shows that the larger part of poverty changes can be explained by economic growth.
3
The remainder of the paper is organized as follows. Section 2 offers some time series
evidence for the finance-investment-growth nexus in Bangladesh. Section 3 compares
Bangladesh's financial system with a number of comparator countries and regional and income
group averages. Section 4 discusses the importance of the macroeconomic environment and of
the contractual and informational framework for financial intermediation and discusses
achievements and challenges for Bangladesh in this area. Section 5 presents three different
views of government's role in the financial system and analyzes the role of the Bangladeshi
government in its financial system and recent development. Section 6 suggests a reform agenda
for Bangladesh's financial sector and section 7 offers conclusions.
2. Finance and growth in Bangladesh ­ a time series analysis6
Financial development indicators, such as Private Credit, Total Deposits and M2 display
an increasing trend for Bangladesh over the period 1975 to 2005, suggesting financial sector
deepening over this period (Figure 3 and Table 2). However, it is also clear that there is a
structural break in 1991, explained by the Financial Sector Reform Program (FRSP), which was
launched in that year and aimed at going from a controlled if not repressed to a more market-
based financial system. Specifically, interest rate controls and credit quota were to be reduced
under this program. Comparing the financial development indicators over five-year periods
shows that they first rapidly increased before a reversal set in the late 1980s and early 1990s and
another improvement from the mid-1990s onward. Figure 3 also shows the positive correlation
between the financial development indicators and the investment to GDP ratio as well as GDP
per capita. This positive correlation, however, does not imply causality between these variables.
6This section is a summary of Rahman (2005).
4
In order to disentangle the causality relationships between financial development, the
investment to GDP ratio and GDP per capita growth, we apply a structural vector autoregression
(SVAR) that imposes long-run structural restrictions on the relationship between the different
variables (Blanchard and Quah, 1989). Specifically, we posit that the short-term real lending rate
impacts financial development, the investment to GDP ratio and GDP per capita. Financial
development, in turn, impacts the investment to GDP ratio and income per capita, while the
investment to GDP ratio only impacts directly GDP per capita.7 As the real lending rate is found
to be non-stationary, first differences are applied for this variable. Annual data are used to
estimate the regression system and lags of explanatory variables are included based on the
Akaike information criterion making all residuals white noise.
The results in Table 3 suggest that financial development has a statistically significant
long-run positive impact on both the investment-GDP ratio as well as on per capita GDP.8 A one
percent positive shock to financial development will generate a positive impact of about 0.15
percentage points on the investment to GDP ratio and a positive impact of about 0.22 percentage
points on per capita income. The finding of a positive impact of financial development on per
capita income even after controlling for the indirect impact through investment activity suggests
that financial development enhances both investment and resource allocation. The estimated
results also indicate that there is a positive and significant relationship between investment
activities and per capita income. In the long-run a one percent positive shock to the investment-
GDP ratio will generate a positive impact of about 0.22 percentage points on per capita income.
The long-run response of financial development, investment and per capita income with respect
to real lending rate changes, however, do not appear with the expected signs, as the results
7Appendix 1 shows the exact derivation of this model.
8Two other indicators for financial development, such as total deposits to GDP and M2 to GDP produce similar
results regarding financial development--economic growth nexus.
5
suggest a positive relationship between changes in the real lending rate and financial
development, the investment to GDP ratio and per capita income.
The positive relationship between financial development, the investment to GDP ratio
and per capita income is driven by the post-FSRP period 1991 to 2005. The results for the
subsample 1991 to 2005 closely match those for the overall sample period. Further, the real
lending rate is significantly and negatively correlated with financial development, investment
activity and per capita income in the post-FSRP subsample. However, the regression results do
not suggest a significant relationship between financial development, the investment to GDP
ratio and income per capita for the pre-FSRP period 1976 to 1991. Whereas the investment to
GDP ratio is positively and significantly related with per capita income over this period,
financial development enters the long-run responses of investment-GDP share and income per
capita with insignificant and negative coefficients.
The insignificant relationship between finance, investment and income for the period of
financial repression matches cross-country experience discussed below and carries some first
important policy conclusions. Specifically, a financial system that relies heavily on nationalized
banks, interest rate controls and directed credit cannot fulfill its important role in channeling
society's savings into investments and fostering economic growth.
3. Bangladesh's financial system in international comparison
The development and efficiency of Bangladesh's banking system is at a comparable level
with other South Asian countries and at a higher level than the average for low-income countries,
while other segments of the financial system, such as the insurance sector and the stock market,
are substantially less developed than in comparator countries. Further, the banking sector has
6
been plagued by systemic distress over the last 20 years. Both the banking system and the stock
market are less developed and less efficient than in East Asia.
To compare financial intermediary development ­ the development of banks and bank-
like financial institutions ­ we focus on three aggregate indicators, which are Private Credit­
claims on financial institutions on non-financial domestic sectors relative to GDP, Liquid
Liabilities - currency plus demand and interest-bearing liabilities of banks and non-bank
financial intermediaries relative to GDP ­ and Bank Deposits­ the ratio of demand, savings and
time deposits in deposit money banks to GDP. Table 4 shows that while all three indicators are
lower than in India for 2004, they are at similar or higher levels than in Indonesia, Pakistan or the
average for South Asian countries. The three indicators are significantly higher than the
averages for low-income countries ­ not surprising, given the low level of financial
intermediation in many low-income Sub-Saharan African countries. Not surprisingly, the three
indicators are below the average for East Asian countries whose financial systems have
recovered by now from the 1997 crisis and whose financial systems have contributed to
achieving middle-income status. Finally, the loan-deposit ratio stands at an exceptional high
80%, i.e. four-fifths of banks' deposits are intermediated into private sector loans. This is even
higher than the East Asian average. However, this ratio has to be interpreted with caution, as the
government directly competes with banks through the National Savings Schemes (NSS), which
go straight into the government's budget, so that there is limited need for direct bank loans to
government, as is the case in many other developing countries.9
9 These NSS are mostly for three to five years of maturity and their sale is restricted to individuals. Their rate of
return is significantly above that of bank deposits, especially since there seems to be a very low penalty for early
liquidation. At the end of 2004, there were 349 billion Taka outstanding NSS, but only 182 billion Taka outstanding
government papers.
7
Overhead costs and net interest margins ­ two negative indicators of banking system
efficiency - are at comparable levels as in other South Asian and East Asian countries and
significantly lower than the average for low-income countries. Overhead costs are banks' total
operating costs relative to total assets while net interest margins are net interest revenue (i.e.
interest revenue from loans minus interest costs from deposits) relative to total earning assets.
Comparing access to and use of banking services in Bangladesh with other countries in
the region and an average for low-income countries suggests that banking penetration is adequate
for the level of financial and economic development. Here, we use a new database on access to
and use of banking services, compiled from regulatory entities and public information for the
years 2003/2004 and discussed in Beck, Demirguc-Kunt and Martinez Peria (2005). Bangladesh
has 47 bank branches per 1,000 square kilometers and four branches per 100,000 people. Figure
4 shows that geographic branch penetration is significantly higher than in comparator countries -
mostly due to the high population density ­ while demographic branch penetration is at similar
or higher levels than in Pakistan, Nepal and the average low-income country, but significantly
below the level observed for India, Indonesia and Sri Lanka. ATM penetration is significantly
lower, with less than one ATM per 1,000 square kilometers and one million people. Figure 5
shows that ATM penetration ­ both in geographic and in demographic terms ­ is significantly
lower than in any comparator country with the exception of Nepal, which suggests limited use of
technology in banking sector outreach. Figure 6 shows that the number of loan and deposit
accounts per capita ­ a positive indicator of the use of banking services ­ is above the level in
Pakistan and the average low-income country ­ while Figure 7 shows that the loan-income and
deposit-income ratios ­ the average loan or deposit account size relative to GDP per capita and
thus negative indicators of outreach ­ are below the levels in Pakistan and the average low-
8
income country.10 Bangladesh has 55 loan and 229 deposit accounts per 1,000 people and the
average loan-income (deposit-income) ratio is 5.2 (1.6).11 While these indicators are only for the
formal banking sector, limited data available for the microfinance sector suggest that access to
and use of formal financial services is higher than in many comparable countries. Honohan
(2004) shows that Bangladesh is the country with the highest microfinance penetration
(borrowing clients constitute 13.1% of total population) in the world, twice that of Indonesia, the
country with the second highest penetration rate (6.7%).12
Other segments of the financial system are significantly less developed than the banking
system. There is a small but growing non-bank financial sector comprising leasing and finance
companies. The indicators of the size and activity of the stock market show the picture of a
small, inactive and stagnant market. Bangladesh's stock market capitalization relative to
economic activity is miniscule as is trading on the exchange, which makes the turnover ratio ­
trading relative to capitalization ­ also lower than in any comparator country. The shares of
financial institutions ­ mandated by law to list ­ dominate the Dhaka stock exchange13; in
November 2005, they constituted 56% of market capitalization and 62% of trading. There were
only two Initial Public Offerings (IPOs) of non-financial companies in 2005 and none in 2004.
There are few incentives to go public and the share of stocks of a typical company traded freely
is very small (Sobhan and Werner, 2003). The insurance sector is small and inefficient ­ life and
non-life insurance penetration (premiums relative to GDP) are at 0.37% and 0.20%, respectively,
below the average for both low-income and the South Asian country average (Table 4). Further,
10Note that deposit and loan accounts per capita and deposit/loan-income ratio are not available for the other
comparator countries in Figure 5.
11Beck, Demirguc-Kunt and Martinez Peria also predict the share of households with bank accounts from their
branch and deposit data. According to this prediction, around 17% of the Bangladeshi population has access to a
bank account, compared to 16% in Pakistan and 37% in Malaysia.
12Note that these data are an estimate as they are based on data from individual MFI; there could be a downward
bias if not all MFIs in a country report and an upward bias if borrowers are clients of several MFIs.
13There is a second smaller stock exchange in Chittagong.
9
life insurance companies undertake reverse maturity transformation, i.e. transform long-term
liabilities into short-term assets, such as bank deposits, which can be partly explained by the
reluctance to issue long-term savings instruments that would have to compete with the NSS.
There are few private pension funds and mutual funds whose development is most likely
prevented by the existence of the NSS that offer rates above deposit interest rates in the banking
sector. Both the pension and mutual fund industry are dominated by public pension schemes and
by the Investment Company of Bangladesh (ICB) that also holds a large part of the shares on the
Dhaka Stock Exchange.14 Unlike private funds, ICB is not subject to Securities and Exchange
Commission (SEC) supervision and has fewer restrictions on its activities, so that private
institutions do not face a level playing field (Sobhan and Werner, 2003). This lack of privately
owned institutional investors has certainly negative repercussions for corporate governance and
stock market liquidity.
The picture painted by the aggregate indicators is confirmed by firm-level indicators of
financing patterns. Firms in Bangladesh finance a lower share of their working capital and their
investment with retained earnings than firms in any of the comparator countries or the average
firm in the average South Asian, East Asian or low-income country, thus relying more on
external finance (Figures 8 and 9). Differentiating between different sources of external finance,
Bangladeshi firms finance a larger share of working capital with banking credit, while private
equity and the sales of stocks play a miniscule role in the financing of working capital and
investment. While financing a larger share of their working capital and investment with banking
credit, firms in Bangladesh report higher obstacles due to access to and cost of external finance
than firms in Pakistan, Sri Lanka, Indonesia and the average firm in the average South Asian or
14It is estimated that ICB holds 20% of shares through their mutual funds and own accounts as brokerage firm
(ADB, 2004)
10
East Asian country and even higher than the average firm in the average low-income country
(Figure 10).15 While the cross-country comparison of subjective assessments of financing
obstacles has to be interpreted with caution, the fact that they paint such a different picture than
other quantitative evidence suggests that we might have to look beyond aggregate indicators and
firms' financing patterns to assess the contribution of the financial system to economic
development and poverty reduction in Bangladesh.
While the aggregate indicators of financial intermediary development suggest a banking
system that might be able to support Bangladesh's move from a low- to a middle-income
country, a closer look identifies a sector that is only beginning to emerge from a crisis. Applying
one of the criteria for a systemic banking crisis (aggregate NPL more than 10% of aggregate loan
portfolio), Bangladesh has been in a crisis since 1983. Currently, gross NPLs stand at 16% and
NPLs net of loan provisions stand at 8% of total loans.16 This aggregate number, however, hides
significant discrepancies across different groups of banks. The government-owned banks or
NCBs (Nationalized Commercial Banks) constituted 40% of total banking sector assets in 2004
and showed a gross NPL ratio 25.3%. The total capital gap, and thus contingent fiscal loss, in
the NCBs was estimated at two to four percent of GDP in 2003. The private commercial banks
(PCBs) constituted 51% of total banking system assets and showed an aggregate gross NPL ratio
of 8.5%. But even within the PCB segment of the banking system, there is substantial variation,
with several older privately-owned banks having been under intensive Bangladesh Bank care for
15Although these are subjective assessments, note that Beck, Demirguc-Kunt and Levine (2006) find that in
countries where firms report higher financing obstacles, industries that depend more on external finance grow
relatively more slowly and investment resources are reallocated more slowly as demand changes across industries.
Also, Beck, Demirguc-Kunt and Maksimovic (2005) find a significant negative impact of financing obstacles on
firm growth.
16Other criteria commonly used to identify a systemic banking crisis include: (i) emergency measures were taken to
assist the banking system (such as bank holidays, deposit freezes, blanket guarantees to depositors or other bank
creditors), (ii) large-scale nationalizations took place, or (iii) the fiscal cost of the rescue operations was at least 2
percent of GDP. Compare Demirguc-Kunt and Detragiache (2005).
11
over a decade due to continuous problems and with other PCBs showing healthy balance sheets
and growth.17 The smallest component of the banking system is made up by 10 foreign-owned
banks that are present in the form of branches, account for 9% of total banking system assets and
have an aggregate gross NPL ratio of only 1.5%.
4. Three pillars of an effective and stable financial system18
This section discusses three building blocks for a sound and effective financial system
and tries to benchmark Bangladesh. We will show that Bangladesh has made great progress in
macroeconomic stability, but still has a long way to go in building the contractual and
informational framework in spite of some promising reforms.
Financial contracts consist of an exchange of money today for the promise of money
tomorrow, thus an enormous leap of faith into an uncertain future. The intertemporal nature of
the contract and several market frictions make financial contracts critically different from other
contracts in a market-based economy. First, there is uncertainty whether today's contracted
repayment (such as interest or insurance payout) or expected repayment (such as dividends or
capital gains in the case of equity claims) will be the same in terms of tomorrow's consumption
units due to inflation. Second, information asymmetries between borrowers and lenders make the
assessment of viable investment projects difficult and lead to principal-agent problems and moral
hazard risks, i.e. the possibility that the borrower will not act in the best interest of the lender.
17There were several waves of PCBs licensed at different points in time, referred to as generations. The first
generation of PCBs was licensed during 1972 and 1989, the second during 1991 and 1996 and the third between
1999 and 2001.
18This and the following section draw heavily on Beck (2006).
12
Similarly, market frictions prevent the costless enforcement of contracts, again increasing
incentives for borrowers to deviate from contracted promises. 19
These market frictions give rise to financial institutions and markets. Financial
institutions take on the role of "delegated monitors" (Diamond, 1984) for savers vis-à-vis
borrowers; financial markets allow the transformation of claims on multi-year illiquid investment
projects into liquid tradable securities. Financial institutions acquire and process information
about investment projects on behalf of their depositors, while prices in financial markets reflect
different information and opinions on new ideas and projects. While market participants have
developed techniques to overcome market frictions, the government has an active role to play in
providing the "infrastructure" for financial service provision, i.e. the rules within which firms
and household contract with each other and perform financial transactions.
4.1. Macroeconomic stability
Given the intertemporal character of financial contracts, macroeconomic stability is a
prerequisite for financial development and a first building block for an effective financial system.
A low and stable rate of inflation provides incentives for financial rather than non-financial
forms of savings. It is also conducive to long-term contracting and thus long-term savings and
investment by providing monetary certainty. Savers are more likely to entrust their savings for a
given interest rate if they can be ensured the expected return in terms of real consumption units.
Similarly, monetary stability allows investors to adequately compute the return on projects and
commit to payments in real terms. Theory and empirical cross-country comparisons have shown
that countries with lower and more stable inflation rates experience higher levels of banking and
stock market development (Boyd, Levine and Smith, 2001). This is illustrated in Figure 11,
19See Levine (1997, 2005) for an overview over theoretical models discussing these market frictions.
13
which plots Private Credit over the period 1980 to 2003 against the average annual inflation rate
for the same period. Similarly, a controlled fiscal government deficit can enhance financial
sector deepening by avoiding crowding-out effects of government spending needs on private
sector lending and investment.
Bangladesh has made great progress in macroeconomic stability, as indicated in Table 5.
Inflation ­ as measured by the Consumer Price Index (CPI) - has been in the single digits over
the last couple of years and while the government deficit has been relatively high in international
comparison, it is lower than in many regional comparator countries and has been stable over the
last couple of years. Further, an increasing share of the deficit has been financed from
concessional donor aid leading not only to lower cost for the government, but also to less
crowding out of private sector lending (Ahmed, 2005).
4.2. Contractual framework
Financial contracts depend on the certainty of legal rights of borrowers, creditors and
outside investors and the predictability and speed of their fair and impartial enforcement. Private
property rights and enforcement of contracts ­ both vis-à-vis other private parties and vis-à-vis
the government - are thus a second crucial pillar of an effective financial system. Savers are only
willing to relinquish control over their savings if they can be sure to receive principal and
contracted interest in return. Outside financiers ­ be they equity or debt holders ­ will only be
willing to invest in companies and projects if their legal claims and rights are upheld. This points
to both creditor rights and minority shareholder rights as being critical for external financing, as
well as the role of corporate governance in both financial institutions and non-financial
corporations. Shareholders do not only need sufficient information, but also the possibility to
14
influence company decisions directly through votes on critical corporate decisions and indirectly
by determining members of the Board of Directors that will ensure that management acts in the
best interest of the equity holders. Critical in the relationship between minority shareholders and
controlling shareholder and management are often problems of looting and of tunneling, i.e. the
possibility for the controlling shareholder to remove assets outside the firms, and the remedial
actions that the legal system offers minority shareholders against them (Johnson et al., 2000).
Creditors will have to be ensured of the fair and quick enforcement of their contracts if the
borrower defaults. This implies the possibility of both enforcing contracts outside bankruptcy as
well as maintaining creditor rights within the bankruptcy procedure. Effective legal systems
provide for timely, efficient and impartial resolution of insolvent borrowers through the efficient
liquidation of unviable enterprises and the rehabilitation of viable businesses.
International comparisons have provided ample evidence for the critical role of legal
system efficiency and its different elements for financial sector development (La Porta et al.,
1997; see overview in Beck and Levine, 2005). The effect of legal system efficiency on financial
intermediation is illustrated in Figures 12 to 14, where we show the positive relationship between
Creditor Rights and Private Credit (Figure 12), the negative relationship between the time period
it takes to enforce contracts and Private Credit (Figure 13) and the positive relationship between
better protection of minority shareholder rights and the market capitalization in stock markets
(Figure 14).
While Bangladesh has made some progress in the contractual framework over the past
years, there is still significant room for improvement. Bangladesh still is ranked as one of the
countries with the highest degree of corruption. While the creditor and minority shareholder
rights are relatively strong on the book (Figures 11 and 13), the enforcement is weak. Lenders
15
and borrowers have to deal with an ineffective collateral system for movable and immovable
assets. Land titling is hampered by poor and unreliable records, high fees, and fraud. The
movable collateral regime is effectively available only for limited liability companies, as these
are the only ones that can register charges with the Registry of Joint Stock Companies (Meagher,
1998). This effectively excludes most of the small and micro enterprises from using such assets
as collateral. These problems have increased reliance of lenders on personal guarantees from
company directors. The bankruptcy legislation is rarely used in practice as a tool to resolve
corporate distress, with less than half of the cases in the two bankruptcy courts actually being
declared bankrupt at the end of the process (ADB, 2004). This is partly due to the stigma
attached to bankruptcy and possible criminal prosecution of bankrupt debtors (Sobhan and
Werner, 2003). While some progress has been made with the recent introduction of the money
loan courts that allow a faster and less bureaucratic enforcement of claims, it is still too early to
say whether this reform has significantly impacted the availability and cost of loans. Further,
appeals to the high court still pose a major bottleneck to the quick resolution of claim resolution
as they are to wait in queue with other cases (Sobhan and Werner, 2003).
The deficiencies in the contractual framework are reflected in cross-country
benchmarking. Bangladesh is ranked 65th in the Ease of Doing Business Indicator (out of 155), a
rank that is driven by deficiencies in the conditions for registering property where Bangladesh
ranked 151st. Bangladesh is ranked 75th in enforcing contracts and 77th in closing a business.
4.3. Informational framework
As financial markets and institutions arise due to information asymmetries that prevent
direct interaction between multiple savers and investors, effective financial intermediation
16
depends on tools to reduce these information asymmetries. The informational framework is thus
a third fundament for effective financial intermediation. International experience has shown that
credit information sharing is important to reduce adverse selection problems and foster
competition in the financial system. Credit registries that give easy and reliable access to both
negative and positive information about clients can dramatically reduce the time and costs of
obtaining such information from individual sources and therefore reduce the total costs of
financial intermediation. Credit reporting makes borrower quality more transparent, which
benefits good borrowers and increases the cost of defaulting on one's obligations. Credit
registries are especially important for SMEs as their creditworthiness is harder to evaluate and
they have less visibility and transparency relative to large enterprises. Consumer rights to access
their information and challenge erroneous information have to be effectively protected to make
such a system a widely acceptable part of the financial system infrastructure and balance
consumer rights with efficiency considerations.
International comparisons have shown that countries with better developed systems of
credit information sharing enjoy higher levels of financial development and their firms report
lower financing obstacles (Japelli and Pagano, 2002; Love and Mylenko, 2003; Djankov et al.,
2005, and Miller, 2003 for an overview). Figure 15 illustrates the positive relationship between
the efficiency of credit information sharing and Private Credit.
Bangladesh has a well functioning public Credit Information Bureau (CIB), established in
1992 and housed in the Bangladesh Bank. It collects data from all banks and financial
institutions that are regulated and supervised by Bangladesh Bank on a monthly basis on all
borrowers, i.e. it collects both positive and negative information. While there is no unique
borrower identifier, the wealth of information of individual borrowers seems to allow a relatively
17
good match. All financial institutions are required by law to obtain information about a borrower
from the CIB before granting or renewing a loan. This provision was introduced in the effort to
reduce non-performing loans in the banking system.
While the CIB has a long and positive track record, several shortcomings of the existing
system should be noted. First, the system is still limited by the lack of computization. Second,
banks effectively only obtain current information about existing borrowers, but no historic
information, i.e. information about past payment performance. One can imagine defaulting
borrower paying up to one institution before taking out new loans with another institution ­ the
CIB reports do not seem to be able to capture such behavior. Third, only financial institutions
participate in the information sharing agreement, other non-financial institutions such as utility
companies, which are a source of valuable credit information about customers in other countries
are excluded. Most importantly, however, the CIB has a stability focus ­ credit information
sharing has the objective to prevent future loan losses, which is an important and valid aspect of
credit information sharing. As important, however, is the function of credit information sharing
in enhancing competitiveness and access to credit by allowing borrowers to create "reputation
collateral", i.e. allow them to use their track record as reference in future loan applications. The
lack of historical information limits such a role of the CIB. More importantly, the threshold of
50,000 BDT (800 USD) excludes the class of borrowers that around the world rely most on
reputation collateral ­ small and opaque enterprises. While technical problems are certainly
recognized, a move towards including all borrowers irrespective of the size of their loans should
be envisioned in the medium-term. Another important step would be to link the existing CIB for
banks and financial institutions to the credit registry to be created for MFIs. Finally, there does
not seem any reason to prevent private credit information sharing, i.e. to change the legal
18
provisions to allow private institutions to provide such services. While it seems unlikely that
such an industry would immediately flourish, it can be an important element in the move of the
Bangladeshi economy from a relationship-based economy to an arms-length economy, which
relies on numerous information brokers, including credit rating institutions and credit registries.
Similarly, more accurate and transparent financial statements can help reduce information
asymmetries between borrowers and lenders. Financial statements that give an accurate picture
of a firm's financial situation reduce screening and monitoring costs for financial institutions and
increase the efficiency of resource allocation. Cross-country comparisons have shown a positive
association of more transparent and comprehensive accounting standards with higher levels of
financial development (Levine, Loayza and Beck, 2000 and La Porta et al., 1997). Similarly,
transparent and more informative financial statements lower information costs for investors and
can foster stock market development and liquidity (Levine, 2003).
A recent World Bank report noted in 2003 that "the accounting and auditing practices in
Bangladesh suffer from institutional weaknesses in regulation, compliance, and enforcement of
standards and rules." While all incorporated companies must file annual audited financial
statements with the Registrar of Joint Stock Companies, there is no effective enforcement of the
timely and accurate filing. A review of published financial statements revealed numerous
compliance gaps. There is limited accounting and auditing capacity and numerous violations of
professional ethical standards. While listed companies are subject to additional oversight by the
SEC, there are legal and judicial constraints to effective enforcement of this oversight. Further,
there seems little confidence in the financial reports issued by companies with no or perverse
19
price effects of such announcements (ADB, 2004).20 More importantly, the costs of going public
seem to surmount their benefits, as public firms are subject to more scrutiny by tax authorities.
5. The role of government in financial service provision
While most economists agree by now on the role of government in providing a stable
monetary environment and government involvement in the contractual and informational
framework, there has been an ongoing debate over the past decades on the role of government as
financial service provider and on the regulation and supervision of financial service providers by
government. This section presents three different approaches to the role of government: the
laissez-faire view, the market-failure view and the market-enabling view. Finally, we will
contrast these views with the current situation in Bangladesh.
5.1. The laissez-faire approach
Under the laissez-faire or invisible-hand approach, there is no role for government
involvement in the financial system. Market discipline rules the relationship between banks and
depositors and between banks and borrowers. Depositors and creditors of financial institutions
monitor them and exercise market discipline by either withdrawing funds or demanding higher
interest rates. Failing banks are taken over by more successful banks or are liquidated. Similarly,
banks monitor and discipline borrowers; borrowers unable or unwilling to repay are liquidated or
rehabilitated through a restructuring process. Under the pure laissez-faire approach, there is thus
no role for government involvement. A modified laissez-faire approach stresses the importance
20Sobhan and Werner (2003) even quote the example where a bank's stock price increased after irregularities in its
lending practices became public, most likely due to manipulating transactions in the market.
20
of macroeconomic stability and the contractual and informational framework and sees a role for
government in providing these necessary infrastructure elements for financial intermediation.
The laissez-faire approach has been criticized for ignoring market imperfections and
failures that lead to a break-down of bank-depositor and bank-borrower relationships as
envisioned in theory. Depositors are not able to monitor banks as they do not have the means to
do so or the costs are too high relative to their claims vis-à-vis the banks. Especially small
depositors have to be protected against loss of their life-time savings. Banks, on the other hand,
have to be protected against runs by uninformed depositors that would force liquidation of long-
term investment projects financed by bank loans. There are also market frictions in the bank-
borrower relationships that prevent optimal resource allocation. 21 Financial institutions might
not necessarily invest in the sectors with the highest social return; banks­ due to their role as
debt holders ­are claimed to have an inherent bias toward conservative low-risk low return
investments, stymieing innovation and growth. By acquiring inside information about firms,
powerful banks can extract informational rents from firms, thus reducing their incentives to
undertake profitable investment. Further, short-term profit-oriented banks might force
borrowers into bankruptcy that suffer only from short-term liquidity problems or they might not
even lend to borrowers with projects that require a long gestation period.
5.2. From market to government failures
Given market failures in the financial systems, the Bangladeshi government took a very
active if not interventionist role in the financial system in the 1960s and 1970s, following the
example of many other developed and emerging economies.22 Through nationalization of all
21See Levine (2005) for a more detailed discussion.
22See Fry (1988) for a discussion of these policies and numerous examples in other countries.
21
banks the government hoped to enhance savings mobilization, direct credit to priority sectors,
and make financial services affordable to larger parts of the population. Through interest rate
controls the government hoped to reduce lending costs for borrowers, while credit quotas were
supposed to guarantee that financial resources flowed to priority and underserved sectors, such as
agriculture. Through specialized institutions, such as agricultural banks and industrial
development finance companies, the government hoped to provide more financial resources for
these sectors. As in many other countries, deposit insurance was introduced to prevent bank runs
and protect small savers.
Government solutions to overcome market failures rely on two crucial assumptions.
First, governments know better than markets; second, governments act in the best interest of
society. Both assumptions relate to the public-interest view, the idea that public authorities
maximize social welfare and have the necessary tools to do so.23 Both assumptions have been
proven wrong in Bangladesh as across the developed and developing world. Bureaucrats have
turned out to have limited knowledge and expertise to run financial institutions and systems and
they do not maximize society's welfare, but are rather subject to political and regulatory capture,
i.e. influenced by the political sphere and the regulated entities, as hypothesized by the private-
interest view.
Bureaucrats as bankers have failed almost everywhere, but especially in developing
countries; economies with a higher share of government-owned banks experience lower levels of
financial development, more concentrated lending and lower economic growth and are more
likely to suffer systemic fragility (La Porta et al, 2001; Barth, Caprio and Levine, 2004). This is
illustrated in Figure 16, which shows the negative association of Private Credit with the share of
23For a in-depth discussion on the public- and private interest views in the context of financial regulation and
supervision, see Barth, Caprio and Levine (2006).
22
majority government-owned banks in the banking system. Bureaucrats have neither the market
knowledge nor the right incentives to properly screen and monitor borrowers and thus ensure the
allocation of society's savings to its most productive use. Being owner, borrower and regulator
of an institution at the same time, governments face obvious conflicts of interest. Experience in
Bangladesh as in many other countries has shown that government-owned banks are often used
by politicians to finance commercially unviable government projects or state-owned enterprises.
Politicians use government-owned banks for electoral purposes; experience across developing
countries has pointed to increased lending in election years and especially to contested districts
(Cole, 2005; Dinc, 2005). The resulting non-performing loans (NPLs) have resulted in large
fiscal costs and often in banking crises as in the case of Bangladesh (Barth, Caprio and Levine,
2004; Caprio and Martinez Peria, 2003). Further, the negative impact of government-owned
banks spreads often beyond these institutions to the rest of the sector: there are efficiency losses
as private sector banks face less competition and governance problems often spread beyond
government-owned banks. An explicit guarantee for government-owned banks is often equated
with an implicit guarantee for privately-owned banks. Cross-country comparisons have shown
that there are fewer possibilities for the private sector to monitor in countries with a higher share
of government-owned banks (Caprio and Honohan, 2005). Below, we will discuss that this is
exactly the situation in Bangladesh.
Worse than government ownership, however, can be a failed privatization process.
Poorly designed and executed privatization processes can lead to fragility and banking crises as
numerous examples have shown over the past 30 years. Studies of privatization processes have
shown the benefits of privatizing government-owned banks, but also the pitfalls (compare
Clarke, Cull and Shirley 2005 and other papers in the same issue). Among the lessons learned
23
from privatization of government-owned banks around the globe are that it is important to open
the books early in the process to thus make the cost of continuous government ownership to the
taxpayer clear to the public and thus potentially create political pressure for privatization.
However, this also points to the recommendation to not recapitalize a bank before privatizing to
thus not ease the political pressure to privatize. While privatization should not be delayed to
minimize fiscal and efficiency losses, fire sales might lead to privatizations to investors that are
not fit and proper or have not adequately assessed the situation of the bank, which might result in
subsequent fragility. There are advantages to divest to a strategic investor who can bring the
necessary management and financial know-how, especially in a weak institutional environment
and to open the privatization process to both qualified domestic and foreign bidders. By selling
to reputable foreign banks, financial systems can benefit from expertise and from additional
resources. Finally, country studies have shown the advantages of full rather than partial
privatization to reduce possible future government influence. By giving up any ownership stake,
government signals that it does not plan to intervene after privatization and that it will not bail
out the new private investors should things go wrong. Privatization, however, is not a panacea,
as privatizing into a non-competitive environment where other elements of the framework
discussed earlier are not in place will not necessarily bring benefits in terms of more private
sector lending.
Credit quotas and interest caps and floors have impeded the efficient allocation of
society's savings to its most productive uses and have especially hurt "smaller" depositors and
borrowers (Fry, 1988). In case of binding ceilings, banks are prevented from charging adequate
risk premiums for riskier and more opaque borrowers or from recovering fixed transaction costs
through a mark-up on smaller loan amounts. Further, competition between credit institutions and
24
for more deposits is hampered as financial institutions have no incentives to become more
efficient or to attract more deposits if they cannot finance more marginal customers. Similarly,
given fixed transaction costs in financial intermediation, floors on deposit interest rates make
savers with small transaction amounts unattractive for financial institutions. Credit quotas have
resulted in fragmentation of credit markets and higher costs for non-priority sectors. In many
cases, financial institutions have found ways around these restrictions, but at a high cost and with
consequent efficiency losses.
While many countries have adopted systems of deposit insurance over the past decades
with the intent to reduce the risks of bank runs, protect small depositors and thus create a stable
and sound banking system, the moral hazard risks coupled with weak regulatory and supervisory
frameworks have often resulted in the opposite. By bailing out not only small, but also large
depositors and creditors, poorly designed deposit insurance schemes have reduced market
discipline, which in the absence of effective bank supervision has often resulted in imprudent
and unchecked risk taking by banks with subsequent fragility (Demirguc-Kunt and Detragiache,
2002; Demirguc-Kunt and Huizinga, 2004). Further, cross-country comparisons have not
confirmed the assertion that deposit insurance is crucial for financial sector development; to the
opposite, countries with more generous deposit insurance schemes are found to have lower levels
of savings and private sector lending (Cull, Senbet and Sorge, 2005).
While strengthening of supervisors' intervention powers has been at the forefront of
efforts improving the supervisory framework, there is little cross-country evidence that
empowering supervisors alone will bring stability. There is evidence, however, that powerful
bank supervisors might be associated with higher levels of corruption. Beck, Demirguc-Kunt
and Levine (2006a) show that firms in countries with more powerful bank supervisors, i.e.
25
supervisors that directly monitor, discipline, and influence banks, are more likely to report major
obstacles due to corruption in lending. On the other hand, a supervisory strategy that focuses on
empowering private monitoring of banks by forcing banks to disclose accurate information to the
private sector tends to lower the degree to which corruption of bank officials is an obstacle to
firms raising external finance. Table 6 reports the results of a regression of Corruption in
Lending on firm characteristics and other country characteristics. We also control for general
financing obstacle to control for the fact that firms that report higher overall financing obstacles
might put part of the blame on corruption. Supervisory power, which is a principal component
indicator of 14 dummy variables proxying for specific power of bank supervisors to intervene in
banks, enters positively and significantly. Private Monitoring, which is the principal component
indicators summarizing the extent to which banks are forced to publish information and the
absence of explicit or implicit deposit insurance, enters negatively and significantly.
While Bangladesh is not part of the Beck et al. (2006a) sample due to some missing firm-
level variables, we can use the regression results to gauge the effect of powerful bank
supervision in the case of Bangladesh. Bangladesh takes a value of 0.44 for Supervisory Power
­ Bangladesh Bank had 11 out of 14 powers summarized by this indicator in 1997 ­ while
Private Monitoring takes a value of -0.80.24 Bank supervisors are thus much more powerful in
Bangladesh than in the average country, but supervision relies much less on monitoring and
disciplining by market participants. 19% of all firms in Bangladesh reported corruption in
lending as major obstacle to operation and growth, compared to 8% across the 37 countries in the
Beck et al. sample. Were Supervisory Power and Private Monitoring at the sample means of
24Unfortunately, there are no data available in the more recent version of the Bank regulation database for
Bangladesh.
26
zero, the regression result reported in Table 6 suggests that this share would fall to 13%, or by
one-third, a quite significant effect.
5.3. Enabling markets ­ a new approach
Rather than replacing market failures with government failures, policies are required that
address market failures directly and try to reduce market frictions. This new approach is not a
laissez-faire approach as it does not leave the market to itself; rather, it relies on the government
to enable and develop markets. It starts from the observation that frictions might prevent markets
from functioning well or might even prevent markets from existing in the first place. However,
this approach does not seek to replace missing or poorly functioning markets, but rather create
the conditions for markets to emerge and function properly. It relies on private institutions to
provide financial services efficiently but takes into account their incentive structure. This
approach foresees a government that works with the market, but does not leave it to the market.
While the government should not be a direct provider of financial services under this new
approach, it has a critical role in ensuring a competitive and contestable financial system. Cross-
country comparisons have shown that countries with lower entry barriers into the financial
system, fewer restrictions on banking and a higher share of foreign-owned banks have more
competitive banking systems (Claessens and Laeven, 2004; Beck, Demirguc-Kunt and
Maksimovic, 2004, Demirguc-Kunt, Laeven and Levine, 2004; Beck, Demirguc-Kunt and
Levine , 2006b). Allowing or even encouraging entry by sound and prudent new institutions,
whether they be domestic or foreign, is important to maintain contestability. But the role of the
government might have to be even more active. Avoiding segmentation in the financial sector
through expanding access to the payment system or the credit information sharing system
27
beyond the commercial banks to bank-like institutions such as cooperatives or regulated
microfinance institutions can help the financial system cater to marginal customers in all
financial services.
The financial safety net plays a critical role in supporting a stable and effective banking
system. Given the maturity transformation ­ using deposits withdrawable at short notice to
finance medium- to long-term loans ­ and given the limited transparency of financial institutions,
banks have been subject to special regulation and supervision not applied to non-financial
corporations. Given the put-option character of bank equity, bank shareholders participate only
in the up-side risk of the bank business and have therefore strong incentives to take too
aggressive risks, ignoring sound and prudent risk management. Effective bank regulation and
supervision, as well as market discipline exercised by large depositors and creditors can keep
bank owners and managers in check.
While there is little evidence that empowering intervention powers of bank supervisors
enhances bank stability, private sector monitoring can have both direct and indirect positive
effects on financial intermediation (Caprio and Honohan, 2004). Monitoring and disciplining by
market participants such as large depositors and other creditors has the advantage of many eyes
instead of just one as in the case of supervisors; further, many eyes might be less subject to
political pressure than the supervisory authority. In addition, market signals in the form of
deposit interest rates, yields on subordinated debt or equity prices of publicly listed banks
moving in response to risk taking and performance of banks provide additional information to
bank supervisors to act on. This signaling mechanism can only work, of course, if coupled with
effective official intervention into institutions that the market has identified as weak. The
28
interaction of market and supervisory monitoring and disciplining can thus be powerful in
reigning in bankers' incentives to take aggressive risks.
Political independence and accountability and protection of supervisors from frivolous
law suits by financial institutions and others are important to prevent political and regulatory
capture. Most importantly, however, is the lack of a government guarantee for shareholders or
large depositors or creditors as this undermines the incentives to monitor banks and consequently
the market prices reflecting banks' risk taking.
While the finding that explicit deposit insurance is associated with more rather than less
bank fragility does not necessarily imply an abandonment of the idea of deposit insurance in
countries where it already exists, careful design of deposit insurance is critical. Limited
coverage and exclusion of certain groups can create a class of creditors ­ such as holders of
subordinated debt, other financial institutions, insiders or large corporations ­ that have the
means to monitor banks and exercise market discipline. Aligning the interests and incentives of
banks and the managers and owners of the deposit insurance scheme by funding and
administering the scheme privately, with limited if any government back-up funding, can further
reduce moral hazard risks. Finally, linking the deposit insurance scheme effectively to the bank
failure resolution system can be critical in reducing the moral hazard risk induced by explicit
deposit insurance and in fostering market and supervisory discipline (Beck and Laeven, 2006).
The main objective of an incentive-compatible bank failure resolution system is the protection of
financial intermediation, i.e. small depositors, borrower-lender relationships and the payment
system, rather than to protect an individual institution and its shareholders.
29
5.4. Government's role in Bangladesh's financial system ­ a status quo analysis
What is the role of Bangladesh's government in the financial system and how does it
compare to the three approaches laid out above? The government has started an important
reform project, which eventually will move the financial system away from the market-failure
approach; however, it is not clear that this reform program involves redefining the government's
role towards that of enabling and developing markets rather than substituting them.25
Starting with the FSRP in the early 1990s, the government has abolished almost all
interest rate controls with the exception of loans supporting export activities. Rather, banks have
to report reference lending interest rates for different sectors and individual lending rates can
only move in a band of 1.5 percentage points above and below this reference rate. While this
still imposes certain restrictions on financial institutions in adequately pricing idiosyncratic risks,
banks can get around this requirement by redefining the sector of the borrower and/or imposing
additional non-interest charges. While the setting of reference rates can certainly improve the
transparence of banks' pricing policies ­ if made public - the restrictions on actual lending rates
to a band rather decreases transparency by forcing banks to non-interest charges and can
effectively ration borrowers in specific sectors. There are no credit directives for privately-
owned banks, while government-owned banks are still expected to lend to priority sectors.
Although it privatized two of the six NCBs in the 1980s and allowed private banking,
Bangladesh started out the 21st century with a banking system dominated by government-owned
banks and several weak privately-owned banks. The dominance by NCBs has fostered a culture
of non-payment, has provided rents to more efficient privately owned banks and has distorted
resource allocation. With assistance from multilateral donors, Bangladesh has recently
embarked on a wide-ranging divestiture program for the NCBs. Loan growth restrictions have
25The reform agenda of the past years is summarized in Ahmed (2005).
30
been imposed on the four NCBs and three of the four institutions are scheduled to be partially
privatized during the coming years to a majority private shareholder; in the fourth institution,
only a minority share is supposed to be sold, while the government will maintain a minority
share in the other three institutions. The restructuring and divestiture process, however, has been
slow and plagued by political interference, resistance from labor unions, and judicial roadblocks.
While Bangladesh Bank is formally independent, this is not reflected in reality. Rather,
anecdotal evidence suggests that the licensing process is a political one, with Bangladesh Bank
following "recommendations" of the political class to allow new banks into the system. This has
also caused a number of weak PCBs, plagued by insider lending and other owner abuse.
The political capture of the regulatory entity also prevents proper resolution of failing
banks. While there is an explicit deposit insurance scheme, it has not been used ­ rather,
Bangladesh Bank has extended an implicit guarantee to all banks. Over the past years, no
domestic bank has been allowed to fail;26 weak banks are being referred to the Problem Bank
Monitoring Department within Bangladesh Bank where they are subject to special supervisory
oversight and certain regulatory restrictions and enjoy regulatory forbearance.27
The dominance of government-owned banks and politically connected private banks and
the reluctance to resolve the weak banks among them result in inefficiencies in the financial
system. As weak banks have to cover loan loss provisions, this drives up the spread between
lending and deposit rates and allows other healthy banks to enjoy rents in the form of higher
profits. The high degree of politicization of financial intermediation might explain the high
share of firms that report corruption in lending as major obstacle as above.
26The only bank to be closed was BCCI, forced by circumstances external to Bangladeshi influence; the Bank was
restructured and reopened as Eastern Bank.
27Pubali Bank spent ten and National Bank three years under the intensified supervision of the Problem Bank
Monitoring Department.
31
Given the politicized licensing process and the implicit guarantee extended by
Bangladesh Bank even for privately-owned banks, bank owners face large and unchecked
incentives to take aggressive credit risk. There are no incentives for depositors or other creditors
to exercise any market discipline given the implicit guarantee. This can explain fragility in the
banking system even beyond government-owned banks in the 1990s. Bangladesh Bank has
responded to this fragility in recent years by following international "best-practice"
recommendations and by strengthening bank regulation and supervision. The capital adequacy
ratio was raised from 8% to 9% of risk-weighted assets and the minimum capital requirement
was raised from 400 million (6 million USD) to 1 billion BDT (15 million USD). Loan
classification, rescheduling, and provisioning rules were tightened and single exposure and large
loan limits introduced. Risk management guidelines were issued. Measures to improve corporate
governance were introduced: the number of board members a financial institution can have was
restricted to a maximum of 13; the time a director can serve was restricted to six years;
shareholding by one shareholder was limited to 10% of capital and only one member from a
shareholding family can sit on the board; banks had to establish audit committees; limitations on
divided payout were imposed and even limitations on expenditures for automobiles and travel
expenses for executives. In order to expand outreach, banks were required to open three banks in
rural areas for every branch opened in an urban area. Bangladesh Bank has gone even deeper
into prescribing banks' operational functioning by issuing job and task descriptions for board
members and CEO and the appointment of a CEO is subject to Bangladesh Bank approval.
Bangladesh Bank has forced the resignation of several CEOs and board directors over the last
few years.
32
While the introduction of these measures has to be understood in the context of replacing
market discipline with supervisory discipline, given that the former is absent in light of an
implicit guarantee, this heavy-handed regulation is partly ineffective and comes at a high cost.
Banks can get around the branching requirement by opening new branches just outside the urban
areas ­ given that the urban areas in Bangladesh are still growing, soon these branches will be
inside the urban areas ­ against the spirit of the regulation. Nevertheless, this regulation causes
sub-optimal allocation of bank branches. Regulations such as for branch opening or prescribing
bonuses and benefits for board members and executives cause additional transaction costs and
cause inefficiencies in banks' operations. Vetting the appointments of new CEOs by Bangladesh
Banks seems rather in the old tradition of operating a financial system than regulating it. Finally,
similar governance measures were introduced later and are still not being enforced for the banks
that need them most ­ the NCBs.
Another indication that bank supervision in Bangladesh is heavy-handed compared to
other countries is the number of professional bank supervisor per institution, which stood at eight
in 1997, substantially above the average of 2.6 for a sample of over 100 countries. 28
Figure 17 illustrates the interaction of government guarantee and supervisory approach.
On the horizontal axis is the degree of government guarantee and on the vertical axis the degree
of supervisory intervention. Given that the Bangladeshi banking system enjoys an implicit
guarantee for depositors and owners, there are no incentives for monitoring and discipline by
market participants. The absence of both market and supervisory discipline (south east corner)
resulted in easy abuse by banks and high risk of fragility in the past. Bangladesh Bank has thus
opted to introduce the above discussed approach of supervisory intervention (north east corner).
28Source is Barth, Caprio and Levine (2006). Unfortunately, there are no more recent data available. Of course, this
high number of bank supervisors also reflects overstaffing in the Bangladesh Bank, and there might certainly be a
bi-directional causality between the size of the supervision department and supervisory interference into banks.
33
Given the continuing explicit and implicit guarantee, the politicization of licensing and the lack
of exit of weak banks, this approach can avoid any "open" failures, but comes at huge efficiency
losses ­ high spreads and sub-optimal allocation of resources across borrowers - and involves
high and increasing contingent losses for the government.
However, Bangladesh Bank has also introduced important measures towards market-
based supervision. Starting some years ago, Bangladesh Bank required banks to go public at the
stock exchange; as a goal, banks should list 50% of their share on the stock exchange. Disclosure
requirements are higher for financial institutions than for non-financial corporations: banks and
NBFI have to publish their annual financial statements in newspapers and ensure availability for
public view in bank branches. Similarly, auditing requirements for banks are more stringent than
for non-financial corporations; Bangladesh Bank maintains a separate list of approved auditors
for banks. So, the first fundaments for a more market-based supervision have been laid. Given
the implicit guarantee of Bangladesh Bank for owners, creditors and depositors of all banks,
however, these important actions cannot serve their function in enhancing market discipline.
6. A financial sector reform agenda for Bangladesh
In recent years, the Bangladesh government has embarked on a wide-ranging financial
sector reform program. While some of the reform measures are consistent with the market-
enabling approach, others are not. Overall, however, a more general paradigm shift is needed, as
we will lay out in the following.
The move to a privately-owned financial system is an important one. But as discussed in
section 5.2., international experience advises caution (but not delay) in the privatization process.
First, such a process should be ideally undertaken by an entity that is independent from the
34
political sphere and will undertake the choice of strategic investors purely on terms of merit not
on socio-political terms. Second, the privatization process should be used to minimize the share
of government ownership and if possible reduce it to zero. The future private owners might not
object or might even welcome continuous minority government ownership; however, this might
send the wrong signal. It might suggest to the market, that the government is not only interested
in continuing to influence decisions in the financial sector that are supposed to be taken by
private actors, but - even worse ­ that it stands ready to bail out the private buyers of the NCBs
if need arises. While the first concern can be addressed by excluding government representatives
from the Board of the NCBs, thus reducing government to a passive minority owner, the second
concern can only be addressed by government's actions and signals play an important role here.
Third, the bank privatization process should be coupled with a resolution of the SOE bad debt
problem. The reliance of SOEs on lending from the NCBs will pose a problem for these banks
even once they are privatized and consequently poses a problem for the government as owner of
the SOEs and regulator of the privatized banks. Finally, the government should ensure a level
playing field between the privatized NCBs and other providers of financial services.29
As important as the transformation of government-owned banks into privately-owned
market players are the de-politicization of the entry into the market and the reform of the exit
process. The licensing process of the financial system has to be put on objective, non-political
basis. While technical issues might impede proper bank failure resolution, such as the lack of a
merge and acquisition provision in the Companies Act, it is especially the political willingness to
resolve failing banks with market-based solutions that counts. Resolving a weak bank through
liquidation or a purchase and assumption operation with the use of the explicit deposit insurance
29This refers for example to Sonali Bank that has the function of a government agent in many localities, which it
effectively gives it a dominant financial market position in these areas.
35
scheme would send an important signal to the market that Bangladesh Bank is moving away
from an implicit guarantee for all financial institutions to a system where it cares about financial
intermediation not about individual institutions. Note that this does not imply embracing the
idea of deposit insurance; rather it encourages the use of an existing but unused mechanism to
move to a market-based bank failure resolution.
These different reform steps will allow Bangladesh Bank to move to a more market-
based regulation and supervision system. This can be illustrated in Figure 17 where divestiture
from NCBs, de-politicization of licensing and a market-based bank failure resolution system
would move the system away from the complete explicit and implicit guarantee to a system with
a limited explicit depositor guarantee (north west corner). In the medium to long term, this
would then allow Bangladesh to move towards the south west corner of the graph, a financial
system with limited explicit guarantee and market-based supervision. Note that this would not
mean a weaker Bangladesh Bank, but rather a regulator with the necessary powers and the
necessary independence to foster market discipline and enhance a market-based financial system.
While the reform agenda laid out above implies a rather radical change in the approach to
the relationship between supervisors and supervised and between government and private sector,
the reform agenda also implies some very concrete initial steps that should accompany the
currently ongoing divestiture process of the NCBs. First, given the large number of banks in the
market a temporary and limited moratorium on new bank licenses should be imposed. Second,
during this moratorium, all banks should be subjected to special audits to assess their long-term
viability. Third, banks that are found non-viable should be resolved, preferably through market-
based solutions such as merger and acquisition or purchase and assumption operations. Fourth,
the legal and regulatory framework for bank failure resolution should be reviewed and possibly
36
reformed. Finally, a medium- to long-term financial sector strategy should be developed that lays
out further reforms in a clear and transparent manner.
While this paper and the policy discussion and recommendations up to now have focused
on the banking system ­ justified as it is the major segment in Bangladesh's financial system -
the analysis carries over to other parts of the financial system and offers critical
recommendations in other areas. While a pioneer in the microfinance movement, Bangladesh
has only recently started to address the issue of regulating and supervising micro-finance
institutions (MFIs). The authorities are currently in the process of drafting a legal framework to
subject to mostly unregulated sector to official oversight by a new entity, i.e. outside the
Bangladesh Bank. While we can and will not go into any detail on international experience with
microfinance regulation and supervision (Christen, Lyman and Rosenberg, 2003) or the
Bangladeshi circumstances, the analysis of government's role in the banking systems offers
conclusions also for this process. First, regulation and supervision should to the extent possible
rely on market participants, which would exclude the introduction of deposit insurance. The new
regulatory entity should be independent but accountable. It should be seen as facilitator not
operator of the microfinance sector. Prudential regulation should be limited to deposit-taking
institutions and should be clearly separated from non-prudential regulation. Finally, a level
playing field should be generated, which implies that financial institutions should be regulated
and supervised according to the products they offer, not according to the legal form they take.
Similar supervisory problems as in the banking system are reported for the stock market
(ADB, 2004; Sobhan and Werner, 2003). While the SEC tries to enhance governance by forcing
companies to hold shareholder meetings and publish audited financial statements within certain
time frames, it also interferes directly into company decisions by prescribing dividend levels,
37
under the assumption that low dividends even if justified by poor performance must be due to
fraudulent management actions. The authority to override the Company Act or Articles of
Association of any corporation is even given by law (Sobhan and Werner, 2003). As the
Bangladesh Bank, SEC can interfere in the appointment of board members and CEOs. While this
is again justified with the underdevelopment of a shareholder culture in Bangladesh, cross-
country comparisons show little evidence for a positive effect of public enforcement on stock
market development, but a positive effect of private monitoring and disciplining; laws that
mandate disclosure and facilitate private enforcement through liability rules foster stock market
development (La Porta, Lopez-de-Silanes and Shleifer, 2006).
Another example is the lack of a "limited liability culture". While Bangladeshi law
recognizes limited liability companies, directors and owners that hold more than a certain
percentage of equity are made liable for any losses beyond paid-in capital with their personal
assets. Similarly, the reliance of banks on personal guarantees of company directors due to the
deficiencies in the collateral regime undermines the limited liability culture. It is a huge
disincentive to serve as independent director on a board's company and a barrier to
entrepreneurship. While this has to be understood in the context of a deficient contractual and
informational framework with weak accounting standards and little protection for minority
shareholders and creditors, it is clearly second-best and provides disincentives for innovation and
entrepreneurship.
7. Conclusions
The financial sector is critical for sustained economic development and poverty
reduction. This paper has argued that beyond macroeconomic stability and an effective and
38
reliable contractual and informational framework, the role of government has to be redefined to
make Bangladesh's financial system more efficient and growth enhancing. Specifically, the
government should move from the role of an operator and arbiter in the financial system to the
role of enabling and creating markets.
It is often argued that the financial sector suffers from the general governance problems
in the economy and the society at large. However, it could be as well argued that financial sector
reform should be in the center of governance reform, since it is here that the money and thus the
temptation is.30 A proper and transparent divestiture process of the NCBs and the de-
politicization of financial sector regulation and supervision can send an important signal to the
rest of the economy and society and be an important catalyst for governance reforms in other
areas. As mentioned above, it can be a catalyst for the redefinition of government's role in the
real economy, as the NCB divestiture process has to be linked to the SOE resolution. Banks that
are effective in monitoring and disciplining their borrowers can serve as catalyst for corporate
governance reform in the non-financial sector (Sobhan and Werner, 2003). An autonomous and
accountable Bangladesh Bank can be an example for institutional reform of other government
entities in the country. Finally, moving from a politicized and interventionist supervision process
to a market-based process can help move the economy from a purely relationship-based
economy to an arms-length economy. While Bangladesh has achieved relatively high economic
growth over the past years with a distorted financial system and in spite of its governance
problems, cross-country experience has shown the importance of financial and institutional
development to sustain long-term economic growth. Now would be therefore the right moment
to address this agenda.
30As the famous bank robber Willie Sutton is claimed to have said: "because that's where the money is", when
asked why he robbed banks.
39
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Appendix: Structural Vector Autoregression Models
In order to investigate the long-run relationship among financial development and investment
and per capita income a system of equations based on the long-run SVARs model is specified
where a set of economically meaningful identification restrictions on the data is required.
Consider the following production function
Y=f(K,AL) (1)
Here, Y = Real output, K = Capital, L = Labor and A = Technology. Dividing equation (1) by
effective labor (AL), we get the following intensive form production function
y=f(k)
We know that change in capital is nothing but investment where per capita income is an
increasing function of investment or capital formation. Therefore,
·
k = I = sy y = f (I) (2)
Where `I' and `s' are investment and rate of saving respectively.
Assuming that investment (I) is an increasing function financial development (F), equation (2)
can be written as
·
k = I = f (F ) (3)
Inserting equation (3) into (2), we get
y = f (I,F) (4)
The above functional relationship among per capita income, investment and financial
development can be expressed as F (financial development) I (investment) y (income per
capita) meaning to say that financial development generates investment and investment generates
higher per capita income. This chain of causality can be expressed as
I = f ( F ) (5)
y = f ( I , F ) (6)
Based on the functional relationship specified in equations (5) and (6) and incorporating a policy
variable, the short-term real lending rate (rlr), we can specify the following long-run functional
relationship among lending rate, financial development, investment and GDP per capita.
et rlr = 1t (7)
et = A21et
F rlr+ 2t (8)
et = A31et + A32et + 3
I rlr F
t (9)
et = A41et + A42et + A43et + 4
y rlr F I
t (10)
Here et is the estimated residual of ith equation from standard VAR model, Aij is the long-run
i
response of ith variables to jth structural shocks and it is the structural shocks from the ith variable
in the system. The restrictions stated in equations (7)-(10) have some interesting implications
regarding financial development-economic growth relationship in that it asserts financial
development has long-run effect on investment and per capita income. Income per capita, on the
other hand, has no long-run effect on financial development. Blanchard-Quah's (1989) technique
of SVARs is employed to estimate the long-run response matrix.
43
Table 1. GDP per Capita Growth and Private Credit
The regression equation estimated is: GDP per capita growth = + 1 Initial income + 2 Population growth +3
Education+ 4Govt. consumption + 5Inflation + 6Black market premium + 7Trade + 8 Private credit. GDP per
capita growth is the real growth rate of GDP over the period 1990-2000. Initial GDP per capita is the log value
measured in 1990. Population growth is average annual log difference in total population. Education is average
years of schooling in 1980.. Government consumption is the general govt. final expenditure as a % of GDP.
Inflation is measured by the annual log difference of the CPI. Black market premium is the overvaluation of the
official relative to the black market exchange rate in percentages. Trade is share of exports and imports in GDP.
Private credit is claims of financial institutions on the private sector, as a share of GDP. All data are averaged over
1980 to 2003 unless otherwise noted.
Log(Initial GDP per Capital) -1.265***
[4.19]
Years of Schooling 0.183**
[2.37]
Log(Government Consumption) -0.434
[0.89]
Log(Trade) 0.25
[0.93]
Log(Black Markey Premium) -0.032
[0.09]
Log(Inflation) 0.02
[0.03]
Log(Private Credit) 1.014***
[4.56]
Population Growth -0.753***
[3.91]
Constant 13.748***
[4.55]
Observations 100
R-squared 0.51
Robust t statistics in brackets
* significant at 10%; ** significant at 5%; *** significant at 1%
44
Table 2. Financial Development, Investment and Income in Bangladesh over Time
Private Total Income per
Period Real lending Investment-
rate Credit to Deposits to M2 to GDP capita in
GDP GDP GDP ratio USD
1976-1980 11.09 6.59 14.86 19.03 10.44 160.0
1981-1985 13.68 13.67 20.23 24.54 10.51 192.0
1986-1990 14.71 19.08 24.75 28.67 13.87 242.0
1991-1995 13.90 16.58 23.07 26.68 17.93 283.0
1996-2000 13.83 23.17 26.70 31.01 21.51 353.0
2001-2005 12.33 28.83 35.08 40.02 22.63 395.0
Sources: On-line version of International Financial Statistics (IFS), IMF, World Development Indicator CD ROM
2003, World Bank. Annual Report and Economic Trends (various issues), Bangladesh Bank and authors' estimates.
Table 3 Estimates for the Long-run Responses to Structural Shocks
This table shows the long-run responses from a one standard deviation structural shock to the real lending rate,
estimated from a structural vector autoregression model rlr denotes the real lending rate, cr_y Private Credit to GDP,
i_y the investment-GDP ratio and y_pcap income per capita in current USD. Z-values are presented in parentheses.
*** denotes significance at the 1% level.
I. Full sample period 1976-2005
et
cr_ y = 0.93***et rlr
(5.42)
et
i_ y = 0.95***et + 0.15*** et
rlr cr_ y
(6.98) (3.44)
et
y_ pcap = 0.84***et + 0.22***et
rlr cr_ y + 0.22***et i_ y
(6.60) (4.29) (6.89)
II. Pre-FSRP period 1976-1990
etcr_ y = 0.63***et rlr
(3.73)
et
i_ y = 0.23***et - 0.03 et
rlr cr_ y
(4.53) (-1.15)
et
y_ pcap =0.26***et - 0.03et
rlr cr_ y+0.11***et i_ y
(4.11) (-0.89) (3.50)
III. Post-FSRP period 1991-2005
et
cr_ y = -0.39***et rlr
(-4.52)
et
i_ y = - 0.14* **et + 0.10*** et
rlr cr_ y
(-3.64) (4.48)
et
y_ pcap =-0.35***et +0.10***et
rlr cr_ y +0.01***et i_ y
(-5.08) (5.42) (3.74)
45
Table 4. Banking and Non-Banking Indicators for Bangladesh in International Comparison
Loan-Deposit Ratio is the ratio of private credit by deposit money banks to demand, time and saving deposits in deposit money banks; Liquid Liabilities / GDP is
the ratio of liquid liabilities to GDP; Private Credit / GDP is the ratio of private credit by deposit money banks and other financial institutions to GDP; Bank
Deposits / GDP is the ratio of demand, time and saving deposits in deposit money banks to GDP; Overhead Costs are the value of a banks' overhead costs as a
share of its total assets; Net Interest Margin is the banks' net interest revenue as a share of its interest-bearing (total earning) assets; Stock Market Capitalization /
GDP is the ratio of the value of listed shares to GDP; Stock Market Total Value Traded / GDP is the ratio of total shares traded on the stock market exchange to
GDP; Stock Market Turnover Ratio is the ratio of total shares traded to average real market capitalization; Life Insurance Premium Volume / GDP is the ratio of
life insurance premium volume to GDP; Non-Life Insurance Premium Volume / GDP is the ratio of non-life insurance premium volume to GDP. All data are for
2004.
Panel A ­ Banking Indicators Panel B ­ Non-Banking Indicators
Loan- Liquid Private Bank Overhead Net Stock Stock Stock Life Non-Life
Deposit Liabilities Credit / Deposits / Costs Interest Market Market Market Insurance Insurance
Ratio / GDP GDP GDP Margin Capitaliza Total Turnover Premium Premium
tion / Value Ratio Volume / Volume /
GDP Traded / GDP GDP
GDP
Bangladesh 0.801 0.389 0.274 0.342 0.026 0.026 0.043 0.016 0.365 0.004 0.002
Indonesia 0.540 0.433 0.210 0.389 0.031 0.048 0.248 0.107 0.430 0.006 0.007
India 0.641 0.616 0.328 0.511 0.022 0.032 0.482 0.548 1.137 0.024 0.006
Nepal 0.367 0.021 0.033 0.004
Pakistan 0.748 0.469 0.257 0.344 0.021 0.028 0.235 0.769 3.268 0.002 0.004
Low Income 0.656 0.294 0.147 0.220 0.058 0.077 0.180 0.096 0.720 0.009 0.007
South Asia 0.677 0.486 0.269 0.402 0.024 0.031 0.229 0.273 1.239 0.009 0.005
East Asia & Pacific 0.712 0.544 0.402 0.456 0.026 0.041 0.510 0.223 0.311 0.017 0.011
46
Table 5. Inflation and Budget Balance Trends for Bangladesh, 2000-2004
Overall budget balance (including capital grants) is current and capital revenue excluding capital grants, less total
expenditure and lending minus repayments.
Bangladesh Low South East Asia
Income Asia & Pacific
2000 2001 2002 2003 2004 2000-2004 Annual Avg.
Inflation, CPI (%) 2.21 2.01 3.33 5.67 3.16 12.39 3.91 6.67
Budget Balance / GDP (%)* -6.47 -5.01 -4.64 -3.38 -3.19 -3.86 -6.13 -3.93
Table 6: Bank Supervision and Corruption in Lending
The underlying model is: Bank Corruption = 1 Government + 2 Foreign + 3 Exporter + 4Manufacturing + 5
Services + 6 Sales +7 Number of Competitors +8 Inflation + 9 Growth + 10 Priv +11 General Financing
Obstacle +12 Supervision + . Bank Corruption is the response to the question "Is the corruption of bank officials an
obstacle for the operation and growth of your business?" General Financing Obstacle is the response to the question
"How problematic is financing for the operation and growth of your business?" Answers vary between 1 (no
obstacle), 2 (minor obstacle), 3 (moderate obstacle), and 4 (major obstacle). Government and Foreign are dummy
variables that take the value 1 if the firm has government or foreign ownership and zero if not. Exporter is a dummy
variable that indicates if the firm is an exporting firm. Manufacturing and Services are industry dummies. Sales is
the logarithm of sales in US$. Number of Competitors is the logarithm of the number of competitors the firm has.
Growth is the growth rate of GDP. Inflation is the log difference of the consumer price index. Priv is claims on the
private sector by deposit money banks as share of GDP. Supervisory Power is a principal components indicator of
the power of supervisory agency to discipline and monitor banks. Private Monitoring is a principal components
indicator of the degree to which regulations force banks to disclose accurate, transparent information to the public
and whether regulations facilitate and encourage private sector monitoring of banks. The regressions are run with
ordered probit. Detailed variable definitions and sources are given in the appendix. P-values are reported in
parentheses. *,**,*** indicate significance levels of 10, 5, and 1 percent, respectively. Source: Beck, Demirguc-
Kunt and Levine (2006a).
Supervisory Power 0.155
(0.006)***
Private Monitoring -0.347
(0.004)***
General Financing Obstacle 0.298
(0.000)***
Observations 2510
Pseudo R square 0.09
47
Figure 1. GDP per Capita Growth and Private Credit
This graph illustrates a regression of real GDP per capita growth on log of initial GDP per capita,
government consumption as share of GDP, trade as share of GDP, black market premium,
average years of schooling, inflation, population growth and Private Credit. Specifically, this
figure represents the two-dimensional representation of the regression plane in GDP per capita
growth ­ Private Credit space. To obtain this figure, we regress GDP per capita growth on all
explanatory variables except Private Credit, collect the residuals, and call them (GDP per Capita
Growth | X). Next, we regress Private Credit against all other explanatory variables, collect the
residuals, and call them e(Private Credit | X ). Then, we plot e(GDP per Capita Growth | X)
against e(Private Credit | X). All data for the regressions are averaged over the period 1980-
2003. Results for the regression are reported in Table 1. Private Credit is the claims of financial
institutions on the private non-financial sector to GDP.
6
)X| 4
thworG 2
taipaCrep 0
P
GD(E -2
-4
-3 -2 -1 0 1 2
E( Private Credit | X )
48
Figure 2: Poverty Alleviation and Private Credit
This graph illustrates a regression of Growth of Headcount against log of initial Headcount, GDP
per capita Growth and Private Credit. Specifically, this figure represents the two-dimensional
representation of the regression plane in Growth of Headcount ­ Private Credit space. To obtain
this figure, we regress Growth of Headcount on log of initial Headcount and GDP per capita
Growth, collect the residuals, and call them (Growth of Headcount | X). Next, we regress Private
Credit against log of initial Headcount and GDP per capita Growth, collect the residuals, and call
them e(Private Credit | X ). Then, we plot e(Growth of Headcount | X) against e(Private Credit |
X). Source: Beck, Demirguc-Kunt and Levine (2004).
49
Figure 3. Financial Development, Investment and Income in Bangladesh over Time
cr_y Private Credit to GDP, dep_y is total deposits to GDP, m2_y is M2 to GDP, i_y the investment-GDP ratio and
y_pcap income per capita in current USD.
40 400
35 350
30 300
et )DS
(U
Ra/oit 25 250
20 200
Ra PDGat
15 150
10 100 piacreP
5 50
1976-1980 1981-1985 1986-1990 1991-1995 1996-2000 2001-2005
cr_y dep_y m2_y i_y y_pcap
50
Figure 4. Branch Penetration Across Countries
Source: Beck, Demirguc-Kunt and Martinez Peria (2005)
Branch Penetration Across Countries
Branches per 1,000 sq km
India
Number of branches per Indonesia
100,000 people Sri Lanka
Nepal
Pakistan
Bangladesh
Low Income Countries
0 5 10 15 20 25 30 35 40 45 50
51
Figure 5. ATM Penetration Across Countries
Source: Beck, Demirguc-Kunt and Martinez Peria (2005)
ATM Penetration Across Countries
ATMs per 1,000 sq km
Indonesia
Sri Lanka
Number of ATMs per
100,000 people Nepal
Pakistan
Bangladesh
Low Income Countries
0 2 4 6 8 10 12
52
Figure 6. Loans/Deposits per Capita Across Countries
Source: Beck, Demirguc-Kunt and Martinez Peria (2005)
Loan/Deposit per Capita Across Countries
Number of Deposits per
1000 People
Average Deposit Size/GDP
per Capita
Number of Loans Per 1000
People
Pakistan
Average Loan Size/GDP Bangladesh
Per Cap Low Income Countries
0 50 100 150 200 250
53
Figure 7. Loan/Deposit-to-Income Ratio Across Countries
Source: Beck, Demirguc-Kunt and Martinez Peria (2005)
Loan/Deposit to Income Ratio Across Countries
Pakistan
Bangladesh
Low Income Countries
Average Deposit Size/GDP
per Capita
Average Loan Size/GDP
Per Cap
0 2 4 6 8 10 12 14 16
54
Figure 8. Sources of Financing: Share of Working Capital
Source: Investment Climate Assessments
Share of Working Capital
100%
90%
80%
70%
60%
50%
40%
30%
20%
10%
0%
Bangladesh Pakistan Sri Lanka Indonesia South Asia Low Income East Asia &
Pacific
Internal funds
Equity and sale of stock
Trade credit (supplier or customer credit)
Informal sources
Commercial bank loans (local and foreign)
Other sources
Figure 9. Sources of Financing: Share of New Investments
Source: Investment Climate Assessments
Share of New Investments
100%
90%
80%
70%
60%
50%
40%
30%
20%
10%
0%
Bangladesh Pakistan Sri Lanka Indonesia South Asia Low Income East Asia &
Pacific
Internal funds
Equity and sale of stock
Trade credit (supplier or customer credit)
Informal sources
Commercial bank loans (local and foreign)
Other sources
55
Figure 10. Financing Obstacles ­ Access to and Cost of Finance
Source: Investment Climate Assessments
Access to/Cost of Finance
0 = No Obstacle; 1 = Minor Obstacle; 2 = Moderate Obstacle; 4 = Major Obstacle; 4 = Very Severe Obstacle
4.00
Access to Finance
3.00 Cost of Finance
2.00
1.00
0.00
Bangladesh Pakistan Sri Lanka Indonesia South Asia Low Income East Asia & Pacific
56
Figure 11. Private Credit v. Inflation
Private Credit/GDP is the claims of financial institutions on the private non-financial sector to
GDP. Inflation is the log of (1 + average annual CPI inflation). Data averaged for 1980-2003.
Sample size: 133 countries.
1.50
1.00
GDP/
Credit
0.50
Private
0.00
0.00 0.10 0.20 0.30 0.40
Inflation
Bangladesh
Figure 12. Creditor Rights v. Private Credit
Private Credit/GDP is the claims of financial institutions on the private non-financial sector to
GDP. Data averaged for 1980-2003. The Creditor Rights Index reflects the legal rights of
borrowers and lenders and measures the degree to which collateral and bankruptcy laws facilitate
lending; the index ranges from 0 to 10, with higher scores indicating that collateral and
bankruptcy laws are better designed to expand access to credit (Doing Business, 2005). Sample
size: 131 countries..
2.00
1.50
GDP/
1.00
Credit
Private 0.50
0.00
0.00 2.00 4.00 6.00 8.00 10.00
Creditor Rights Index
Bangladesh
57
Figure 13. Contract Enforcement v. Private Credit
Private Credit/GDP is the claims of financial institutions on the private non-financial
sector to GDP. Data averaged for 1980-2003. Days to Enforce a Contract is an indicators
that measure the efficiency of the judicial (or administrative) system in the collection of
overdue debt; it is the time required for dispute resolution, recorded in calendar days,
counted from the moment the plaintiff files the lawsuit in court until settlement or
payment (Doing Business, 2005). Sample size: 131 countries.
2.00
1.50
GDP/
1.00
Credit
0.50
Private
0.00
0.00 500.00 1000.00 1500.00
Days to Enforce a Contract
Bangladesh
Figure 14. Minority Shareholder Rights v. Stock Market Capitalization
Stock Market Capitalization / GDP is the ratio of the value of total shares outstanding to
GDP. Data averaged for 1980-2003. Investor Protection Index measures the strength of
minority shareholder protections against directors' misuse of corporate assets for personal
gain; the index ranges from 0 to 10, with higher values indicating better investor
protection (Doing Business, 2005). Sample size: 93 countries.
2.00
GDP/ 1.50
1.00
Capitalization
Market 0.50
Stock
0.00
0.00 2.00 4.00 6.00 8.00 10.00
Investor Protection Index
Bangladesh
58
Figure 15. Creditor Information Sharing v. Private Credit
Private Credit/GDP is the claims of financial institutions on the private non-financial
sector to GDP. Data averaged for 1980-2003. Credit Information Index measures rules
affecting the scope, accessibility and quality of credit information available through
either public or private bureaus; the index ranges from 0 to 6, with higher values
indicating that more credit information is available from either a public registry or a
private bureau to facilitate lending decisions (Doing Business, 2005). Sample size: 131
countries.
2.00
1.50
GDP/
1.00
Credit
Private 0.50
0.00
0.00 2.00 4.00 6.00
Credit Information Index
Bangladesh
Figure 16. Share of Government-Owned Banks v. Private Credit
Private Credit/GDP is the claims of financial institutions on the private non-financial
sector to GDP. Data averaged for 1980-2003. Share of Government-Owned Banks is the
fraction of the banking system's assets in banks that are 50% or more government owned
(Barth, Caprio and Levine, 2006). Data are for 1997. Sample size: 92 countries.
2.00
1.50
GDP/
1.00
Credit
Private 0.50
0.00
0.00 0.20 0.40 0.60 0.80 1.00
Share of Government-Owned Banks
Bangladesh
59
Figure 17: The interaction of government guarantees and supervisory approach
Powerful
Bangladesh
supervision Divestiture
Market-based BFR
Reduce
restrictions
on banking
and
branching
Easy abuse by banks
Risk of fragility rises
Government guarantee
60